Cash Flow Adequacy

What is “Cash Flow Adequacy”?

The cash flow statement presents the change in cash from one period to the other. The key four components of a cash flow statement are cash flows from operating, investing and financing activities and reconciliation of net cash flows, which is the sum of the aforesaid three flows.

Cash flow adequacy measures whether the cash flow that a company generates from its operating activities for the period, is sufficient to cover payments due on long term debt, fixed assets purchased and dividend paid to shareholders.

Importance of Cash Flow Adequacy and Key Metrics

The concept of cash flow adequacy is important, as the bank that lends money to a company is primarily concerned with whether a company generates enough cash to service its debt (i.e. loan) and pay back the same. For lenders, it is less risky to lend to companies who have strong operating cash flows (OCF).

The three key metrics to focus on, from the point of view of assessing cash flow adequacy, are Funds from Operations (FFO), OCF and Discretionary Cash Flow (DCF).

FFO estimates a company’s ability to generate reoccurring cash flows, independent of fluctuations in the working capital. Therefore, it leaves out changes in working capital, capital spending and discretionary items (for example, dividends, acquisitions).

OCF is the cash generated from the business operations of a company and this includes working capital. But it ignores the requirement for a company to replace fixed assets either for growth or maintenance. The OCF can be used to calculate the Cash Flow Adequacy Ratio. This ratio is an important liquidity ratio and is computed using the following formula:

Cash Flow Adequacy Ratio = Operating cash flows (i.e. cash flow from operations) / (Long Term Debt + Fixed Assets Purchased + Dividends Paid

*Long Term Debt refers to debt repayment on long term debt (i.e. paying down of debt).

The OCF is compared to the payments made for reduction of long-term debt, purchases of fixed assets and dividends that are paid to shareholders.

This ratio is used to analyze if a company is generating enough cash from its operations to support the aforesaid expenses. If the ratio exceeds (lower than) 1, it means that the company is (not) generating enough cash to cover the aforesaid expenses.

The DCF refers to the cash generated by the operations of a company less capex. It ignores the debt maturity, but includes dividends to shareholders even though they rank below interest payments.

Example- OCF, FFO and DCF

Given below is a workout in which the OCF, FFO and DCF of a company for a period (year) have been calculated. The OCF has to be calculated, in order to compute the cash flow adequacy ratio (below) of a company.

In this workout, income and expenses are presented in US$ (million), as they are in the income statement of Company A. From these figures the OCF, FFO and DCF have been calculated.

We start with the column “Cash Flow,” which shows actual cash flows. We take the numbers as they are presented in the financial statements and convert them into actual cash flows. This in turn helps us in constructing the formulas for OCF, FFO and DCF – refer to the workout.